Doriot’s first principle is what I’ll call the “new factor.” Doriot believed that venture investments investments involve new technology, new marketing concepts, and/or new product applications. The driving force behind this policy is that venture investment needs something unique and novel that addresses an unmet need. The reason, of course, is a question of competition. If you’ve got the only solution, everyone with that problem has to come see and pay you for the remedy.

To understand the effect of having new technology, look at the effect of any modern industrial revolution. The gasoline powered engine disrupted so many traditional markets and economies from buggy whips to horse shoes. That’s the point of the “new factor,” you need something that disrupts in a life-altering way.  New product applications can recreate the life cycle of a technology. Do you think the original intention of the Internet was streaming video and digital music? There is probably no better example of new product applications that the internet and its seemingly unlimited number of applications.

The tricky part of this issue is not accepting the necessity of new technology or product applications. Those are relatively tangible ideas that we can wrap our minds around. The difficult part is understanding the role of a new marketing concept. A great case study for this discussion is hotmail.com. Hotmail, while an early email platform, was not the first of its kind. Its unique and competitive element, crated with the value-add of investor Tim Draper, was the creation of viral marketing through the email invitation system. Hotmail was one of the first platforms to do invitation only type services. Like most modern applications, invitation only is really not designed to choke off usability. Instead, its designed to force conversation about the product as people search for users in order to gain an invitation. It creates buzz and raises the profile, almost providing an air of exclusivity.

All entrepreneurial opportunities need some kind of “new factor” in order to capture and hold the market, but high-growth opportunities that seek venture investment need a life-shattering newness.

Next up, I’ll talk about the need of investors having a controlling interest in their investments.

Check it out.

Background

I previously wrote on this issue on December 10th. You can find that post here.

Also, here is a really solid post from Jason Mendelson, a VC (Foundry Group) in Builder, Colorado.

From the legislative perspective, a change to carried interest taxation from capital gains to ordinary income for all asset classes was included as a “pay for” in the Tax Extenders Act of 2009. This bill is designed to provide a short term tax break for big industry and passed the House of Representatives with a clause to increase taxes on carried itnerest for all asset classes. Fortunately, the senate version of the bill did not include carried interest as a revenue source. Unfortunately, the health care reform legislation that passed created a $30 billion shortfall and put carried interest as a pay-for provision back on the table since many of the identifiable sources of revenue have been fully tapped. Mind you, the Tax Extenders Act of 2009 was written to provide short term tax extensions for large corporations. Now, a long term tax penalty for those who foster small business growth and job creation is being presented as the solution. You can read more by visiting the public policy page for the National Venture Capital Association (NVCA).

More than 1,700 stakeholders from VC and start-up communities urge protecting VC carried interest. See press release from NVCA here.

More than 1,400 CEOs, company founders, and entrepreneurs support preserving capital gains tax status for VC carried interest. See press release from NVCA here.

How are VCs compensated? What is carried interest?

Let’s spend a couple paragraphs and provide a little perspective on compensation in the venture capital industry. Typically, senior staff (i.e. general partners, fund managers, etc) in a venture capital fund receive compensation in two ways. First, they receive an annual salary that compensates them at a base level. In my experience this is typically a healthy salary, but it may not be competitive with the salary many of these men and women would demand if they worked in other industries. Also, this compensation is taxed as ordinary income at 35%, just like the salary most anyone earns.

The larger motivator of performance for senior staff is the carried interest benefit (Investopedia article here) they receive on the returns of the fund. Most funds are structured in a way that all paid-in-capital is repaid to limited partners as a primary obligation, before the senior staff receive any payouts. After that principle amount is repaid, the remaining amount is split between the general partners and limited partners as “carried interest.” It’s important to note that their is no guarantee of this return, it typically occurs over a long period of time (8-12 years, by my estimate), but has unlimited potential upside based on the performance of the fund. This serves to keep the senior staff motivated to work for the long-term goals of fund performance. Currently, carried interest is taxed as capital gains at 15%. The rationale has been that this return is not guaranteed, is directly attributed to investment performance, and is earned over a long period of time.

To be clear, I am not “venture capital senior staff” but I’d like to be one day (in the not too distant future, hopefully). I’ve spent three years working in a venture fund, and while I’ve loved it, I’ve seen our senior staff work incredible hours into the late night and weekend, spend weeks at a time traveling, and do an excellent but difficult task of balancing their personal and professional lives. All of this is done for years without any guarantee that the long-term carried interest benefit will even materialize. I don’t want to provide some knee jerk commentary on how adjusting this tax rate effects my career plans, but this is certainly something I’ll be thinking about.

Why is this a big deal?

Aside from raising taxes an incredible 133% in a single action (would any industry do well with that kind of radical adjustment to its tax structure occurring overnight?) let’s look at the downstream effects of having a healthy venture capital economy. Venture capital backed companies represent more than 500,000 jobs in our country, and have added thousands of new positions each month through the recession. This is only a small piece of the pie, as it doesn’t even consider the publicly traded companies that originally received venture investment. Those companies–including HP, Microsoft, Apple, Xerox, etc–are estimated to represent 11% of America’s workforce. Take into consideration the thousands of smaller supporting companies that exist as a product of the industries these companies have created, and the over all economic impact is staggering. According to the Small Business Administration, over 60% of workers are employees of small businesses. What does all o this mean? According to a 2009 Global Insight study, venture-backed companies accounted for 12.1 million jobs and $2.9 trillion in revenue in the United States in 2008. America is envied across the globe for its economic engine because no other country has proven to be as innovative, and entrepreneurial. This gives America the flexibility, resilience, and strength that puts us in the driver’s seat for the world economy.

Some people take issue with the idea that multiple tax rates exist. For the sake of discussion and background, I’ll explain the theory of having a capital gains tax rate. The theory of capital gains is that we should encourage those activities that most spur stable long-term economic growth. Having a capital asset class that is dedicated to the creation and growth of companies is a critical part of accomplishing that goal. Allowing carried interest to be treated as capital gains allows rewards job and wealth creation, and it also allows more capital to be available for continued investing.

Ultimately, tweaking the economic model that drives venture capital investing is like cutting off your nose to spite your face. Trading off short term tax relief for big business on the back of long term tax burden to economic agents of entrepreneurship and small business doesn’t make sense. Where does most job growth come from? Small business. If you strangle off the agents that support small business, you effectively take a critical piece out of the entrepreneurship and small business ecosystem.

Don’t stream, who knows what the effect might be? There has been discussion by some of our foreign competitors to adjust their tax structures to completely exempt VCs from start-up investing. Would you like to see our economic engine gone to Russia and China? There is already data showing an increase in VC investment activity overseas.

Misconceptions

Venture capitalists did not cause the economic recession we are currently experiencing, but we have certainly felt the effects of it. I’ll let smarter and braver heads than mine go about explaining who did.

Venture capitalist do not operate the same as billion dollar hedge and buyout fund managers. We invest in private opportunities, not the public markets. We typically manage smaller amounts of capital and are highly involved and engaged in our investments. Our investments are small businesses with incredible potential. While many of them fail to survive the turmoil of being a start-up, the ones that do historically create jobs and wealth that greatly outweigh the losses.

Venture capitalists do pay ordinary income taxes on their salaries, the same as most every working man and woman. The capital gain tax status is assigned only to those returns earned as a result of effective investments. As I said before, the time horizon for these returns is long-term and undefined. In addition, there is no guarantee of these returns.

I’m not sure where technology goes next with streaming content, but I think we have a convergence of traditional content and internet streaming in the not too distant future. Some how, entrepreneurs have to manage the dynamic environments of electronic devices (run for the hills, it’s the iPad) and streaming content. To top it off, we’ve got to build out the infrastructure to have the bandwidth to accomodate all of it. I’d expect a media mogul to attempt something like that, but the current generation is still trigger shy after Time Warner got slapped around with the AOL deal. Mind you, that parent owns HBO… so maybe we’re seeing some down road benefit of that catastrophe. Oh, and Google is also on the job (remember Google TiSP from 2007… yeah, it was a joke, but apparently they were thinking about connectivity to residential households).

If Netflix really wanted to put some pressure on the big media business, they should do a couple of things (in my not-so-humble opinion):

• Provide a rotating streaming big ticket picture on a weekly basis
• Provide the opportunity to stream weather and local media
• Provide streaming of live sporting events
• Build a library of musical performances

If we can keep technology and entrepreneurship on the tracks, we’ve got some real value-add developments coming. It takes a few years (late 90′s and early ’00′s) of stupid wasteful foolish risky ventures to help focus in on the viable opportunities. The show ponies are dieing off and the stallions are left behind. They may not get the attention of show ponies, but that’s because they’re stallions… they do –gasp– work. Our entrepreneurial communities aren’t dead, they’re focused on survival and committed to their concept. But enough of that, or I’ll start talking about the blasphemous and offensive fact that increasing government expenditure decreases small business growth and innovation.

I thought I’d write a few words about how I’ve prepared. I’ve looked over all the presenting companies and developed a short list of companies in our profile and/or that look attractive. I’ve reached out to most of those companies through emails or phone calls to make initial introductions. The way the conference is organized, their isn’t a real bullpen area where you can easily locate the companies. Plus, with so many potential investors in one place, it can be challenging to get the attention of folks. Even VCs get lost in the crowd when the crowd is other VCs. Same thing, if not more so, for entrepreneurs. I also plan to drop emails and calls to certain colleagues that tend to attend this event. It gives me an opportunity to catch-up with those folks, gaining valuable insight on how active they are and what areas they’re looking at.

After looking over the list of presenters, I noticed a few trends: lots of web-based platforms (i.e. accounts receivable, entertainment management, etc), lots of companies touting “cloud computing,” and a noticeably less “clean tech” companies. Make out of it what you will, but those are my observations. Also, here’s a good article on cloud computing that I stumbled across at Venture Beat.

Here’s some quick-and-dirty advice for presenting at one of these opportunities:

• You only get 5 minutes, so focus on the material the audience cares about. Sorry engineers and technologists, that probably doesn’t include CAD sketches and technical analysis.
• If you’re raising money, investors want to know– how will you make me money and how much money will you make me? Period. End of discussions. Please, no CAD sketches or technical analysis.
• Do not read off the slides. In fact, use the slides for context and support, not as the foundation of the presentation. Your personality, passion, and speaking should be the foundation.
• Investing is relationship driven, whether institutional or individual, so don’t forget to introduce and give context for your leadership team. But remember, you aren’t the product, so don’t act like it.
• Want other advice than mine, then checkout this post from Guy Kawasaki… The guy is an authority on presentations. Don’t believe me, just watch the video below:

Unfortunately, members of his own party were not listening.  Or, maybe they were but they chose to disregard the president’s guidance. Yesterday, without a public hearing or committee vote, the Democratic controlled House of Representatives voted to raise the tax rate on carried interest paid to equity fund managers to 35% from 15%. This 133% increase was accomplished by reclassifying carried interest from a capital gain to ordinary income. That’s why today’s headlines should read “House of Representatives Loves High Unemployment, Punishes Job Creators.”

How Does Venture Capital Work?

While this bill applies to many investment groups—including broader private equity, real-estate partnerships, and oil-and-gas partnerships—my perspective is focused on the affect of small business growth resulting from venture capital investment. Venture capital is high risk portfolio style investing that utilizes equity and equity-like investment tools for the purposes of providing development and growth capital for start-up companies. Companies fitting this profile typically have a curve-jumping quality, focus on an underserved and growing market, and have all kinds of risk due to their infancy, sensitivity to the overall economy, and dynamic change factors. As a result, most venture investing is done with a portfolio approach and with a significant return-on-investment expectation.

Investment capital is typically raised from institutional partners such as endowments and pensions, with the occasional inclusion of a high net worth individual. These investment partners compensate a staff, led by fund managers, to manage the investment capital and the portfolio investment. This staff has two methods of compensation, through an annual management fee and with a carried interest bonus upon liquidation of the fund. The management fee goes to pay all expenses, including salaries of the fund, for the life of the fund—typically around 10 years. In my experience, staff members have lower salaries than they could find in other industries, with the majority of their compensation coming in the form of the carried interest bonus. For purposes of this conversation, these salaries are taxed as normal income.

Over ten years, the fund may invest in a handful of companies. Some of those companies may fail, some may break even, and a small number will make a significant return. At the end of the fund, the goal is to return all investment capital to the investment partners, plus the additional money made off the fund. A portion of this additional profit is set-aside as a carried interest bonus to the management team. Traditionally, this bonus has been taxed as a capital gain because of the nature of its source—the money comes from a successful investment and is not a guaranteed return. The money occurs after many years of tedious and patient management of investments.

Changing the tax structure on carried interest changes the economics of incentive for the people that work in venture capital. As financiers, we’re very sensitive to the idea that there is a cost to the capital we deploy. If we fail to meet that hurdle, our investors will look for other investment opportunities. Likewise, there is a cost to the time and resources we commit to managing that capital. If our compensation doesn’t justify the stress and commitment necessary, we’re likely look for alternatives. Ultimately, less potential carried interest return to the management team leads to increasing salary compensation, which results in less capital available for deployment. The other alternative is that we run the risk of venture capitalists seeking careers in other industries. While there are arguably too many funds active today, the mind set and culture of the venture capitalist is a rare animal. Run too many of them off, and you’ll find this to be an endangered species and industry.

Why Should I Care?

To put it bluntly, venture capital provides a unique and critical service to our economy—capital and guidance for start-up companies. According to U.S. Census Bureau data, companies less than 5 years old created nearly two-thirds of net new jobs in 2007. While not all of those companies were candidates for venture capital, a substantial number of them were rapidly growing businesses serving unique market needs. These companies often lack the assets or history to secure debt, making an equity investment like venture capital a lone source of financing. Without access to capital, those companies grow at much slower rates or even close down completely. Our small business economy isn’t a recent phenomenon; it’s been the staple of our economy for the past fifty years. The small business economy and innovation spurred companies like Microsoft, Apple, Oracle, and Amazon to name a few.

Tinkering with the economics of venture capital is playing a dangerous game.  While the short term intent may be to supplement incentives in other areas of the economy, the long-term effects may be regression of small business growth and capital deployment. Why punish a critical piece of the mechanism responsible for two-thirds of business growth?

On deals (micro-economic):

• 2008 average investment per deal was $276,918
• Average number of investments was 6.3
• Average number of new investments was 3.7
• The largest identified sweet spot, with over 40% support, was between $250,000 and $500,000

On the investing (macro-economic):

• More than 2/3rds of respondents think current economic conditions will extended until 2010
• Uncertainty of the economy, a desire to preserve capital for follow-on investment, and loss of wealth were identified as the primary reasons for closing less deals
• 2009 will bring more quantity and quality deals for angels
• The current environment is providing more attractive (author’s note: and realistic) valuations
• Nearly 3/5ths of respondents expect the liquidity time line to be greater than five years
• Respondents expect to increase their co-investment with other angel groups, early-stage VCs, and individual angels
• Angels are increasing management activity and follow-on investing

Basically, Q2 of 2009 showed some signs of life out of the IPO market with five offerings, four from into tech and one from non-high tech. While we’ll celebrate those as the first real high technology IPOs since Q1 2008, we can’t over do it. We’re still a long way from the IPO payday; for example, in 2007 there were 86 IPOs for the year. The IPO market imploded in January of 2008, which in hindsight was probably an early sign of the financial fiasco we’re still struggling with to this day. I still feel like lots of politicians were trying to talk us into a little recessionary dip with pre-election angst and finger pointing, but in retrospect I don’t think I paid enough attention to the stalling IPO market. But I digress…

The venture industry needs liquidity events. Right now, many funds have all capital tied up in portfolio companies that can’t exit even though they’ve reach profitability, or the fund is tied up pumping capital into companies unable to raise additional outside equity. Either way, funds are limited on their ability to engage in real value-add, early stage investing. In addition, some funds are taking huge cram-downs and dilution as portfolio companies go through recapitalization and down equity rounds (i.e. raising money at lower valuations than before). Now, I’m not waving a “poor pitiful VC” flag. I’m just saying we need a healthy, vibrant, and liquid venture industry to keep entrepreneurship going.

The thing about entrepreneurship and early-stage investing is that it’s an expertise lost to the general public and most public officials. Frankly, you don’t really hear major media reporting on innovation, new business creation, IPO registrations, and patent filings. It’s all too complicated for the average Joe or Mary, so real high-growth entrepreneurship seems reserved to those fringe elements of society. Lots of people want to claim some title in this arena (angel invstor, entrepreneur, etc), but few of them really have the somatch and even less ahve the know-how. In addition to the complexity and unknown of this space, the target is always moving as a result of disruption and hyper competition. In my experience, working in this industry requires a high level of commitment to learning and a deep humility/sensitivity to how much you need to learn and relearn each and every day.

In conclusion, we’ve seen some sign of life in the IPO market, but we’ve still got a lot of capital clogged up in venture-backed companies. Exits are approximately 60% of their high over the past five years, with IPOs still anemic.

Here are some graphs showing venture0-backed liquidity events in the US (sorry for the poor pic quality):

The journey through that wilderness isn’t without the occasional victory. One of the earliest inflection points of a start-up is securing that first round of outside investment. Right as the entrepreneur has almost topped out their credit cards, exhausted their savings, and been banned from family dinners due to borrowing from relatives… the oasis appears!

In the life of a start-up, there are few events more exciting than raising the initial round of funding. This initial round, often called the seed round or seed capital, is some of the most critical but most difficult to raise. This money goes for flushing out the business model, building the prototype, protecting the intellectual property, getting critical market validation, and beginning to generate early adopter revenue.

In addition, it marks an important point in the entrepreneurs maturity. They’ve probably gone a few months without an income… and outside investors mean an actual paycheck. It feels so good, they won’t even care that the salary is 1/3rd what they could earn in corporate America.

Unfortunately, there is a problem with securing seed money. The risk and lack of revenue associated with a seed investment is a turn off for most institutional investors, and most high net individuals are too busy investing in real estate (or maybe that’s just in East Tennessee?). As a result, many potential entrepreneurs lose hope, run out of savings, and eventually throw in the towel. While this lesson is critical for technology start-ups, it happens across the board, from lifestyle, to serial, to social entrepreneurs. Academics have identified a funding gap between traditional venture funds (which focus on growth and expansion opportunities) and seed investments.

In order to be successful at raising seed capital, and to avoid major complications in later stages of fund raising, entrepreneurs should develop a fund raising strategy. The idea that “all money is good money” is a bad idea that gets good entrepreneurs into horrible, dead-end situations. Remember, there is no such thing as a free lunch… so consider the conditions (both legal and implied) that come with every outside dollar you raise. Make sure every dollar raised creates the kind of value that grows the company beyond seed and into the growth stages.

Some points for consideration are as follows:

Seed Stage Funding Sources:

• FFF– The classic friends, family and fools. Unless an effort is backed by a research institute or corporation, most start-ups rely on founder’s capital and resources to get the concept nailed down, technology flushed out, and business plan pieced together. It can be very beneficial to be an early investor, since this money gets to experience the most value gain over time. Likewise, early investors typically get diluted (or see a decreasing stake in the company) with the entrance of larger institutional players. That’s usually okay, though. Institutional money can make the difference between owning 20% of a hot dog stand of 1% of a MacDonalds. Be careful with FFF and how the deal gets structured. Later in the companies maturing, it will be tricky to raise money if the earlier investors are at odds with potential future investors.
• Grants– Free money! Well, mostly free besides the time spent battling the annoying application process. Common resources for grants are federal grants like the Small business Innovation Research grant. Aside from providing capital, these awards are 3rd party validation for the concept.
• Boot Strapping–Boot strapping is the funding strategy for most non-serial, non-technology entrepreneurs. This is a great way to establish a lifestyle company (one with no desired exit, but with intent of operating under founder’s control to provide income for a certain lifestyle). As revenues grow, the company is able to increase its relationship with the bank, throttle up cash flow, and expand operations.
• Angel Investors–Angel Investors come in many shapes and forms, which makes it difficult to understand what someone means when they claim to be an “angel investor.” Also, there are lots of decoys out there… people claiming to have access to angel money but with no real ability to invest. Depending on what the angel brings to the table, the deal should be assembled accordingly. An angel with industry experience and a willingness to serve as an adviser or board member should have more seniority and stronger investment rights. An angel without the resources or acumen should be treated as a typical FFF investor. Some would even argue that angels without special resources or acumen aren’t really angels… they’re really just part of FFF fund raising.
• Institutional Seed Investors–Before its all said and done, almost every technology start-up needs some kind of institutional investment. Institutional investors are the true commercial venture and private equity funds. Venture and private equity money is supposed to be “smart money.” Be careful… there are many groups passing themselves off as venture funds without the resources (and most importantly capital) to support their claim. A real institutional investor will have provide the start-up with access to their network (both industry specific and fund raising), provide operational value as an adviser or board member, and be able to offer fresh and relative opinions.

Concerns:

I can’t believe I’m making this recommendation, but when it gets time to negotiate the terms of a seed round, I recommend the entrepreneur bring their own lawyer to the table. Certain lawyers specialize in business formation and investing, so they have the acumen necessary for writing the appropriate investment documents.

• Valuation– This needs to be a post all its own. Raising too much money or at the wrong valuation cause cause major problems in the long run. The most frequent mistake of naive and rookie entrepreneurs is trying to raise money at too high a valuation. Typically, $500k seed investment in a company that is pre-revenue, pre-prototype, and pre-IP (patent) is going to purchase 35% to 45% of a start-up. This isn’t written in stone, but its a good starting point for negotiations. The longer the company waits to raise seed money and the more value squeezed from founder’s capital, the better the valuation. For example, a company raising a frist round of seed money that already has a patent filed, a prototype built, and recurring revenue off a small number of beta customers is going to give up much less than a company with only a business plan and pitch.
• Anti-Dilution– Some companies are tempted to include an anti-dilution clause, which is a BAD idea in my opinion. Early ivnestors should have tag-along rights (or the option to invest pari-passau) with future rounds. The harsh reality is that most early investors, won’t have the cash reserves to follow-on with later institutional investments. As the multi-million dollar investments close, ownership percentage becomes diluted for both early investors that don’t participate and founder’s equity. This is natural and to be expected, so entrepreneurs should manage expectations with the FFF. Like I said earlier…. 10% of a hotdog stand or 1% of a MacDonalds.
• Investment Tool– There is much debate around what type of tool to use with seed investors. Typically, investments are made as either common stock, preferred participating convertible stock (yeah… a mouthful!), or as convertible debentures. Personally, I think REALLY early institutional seed money should be raised as convertible debentures, founder’s equity should be treated as common stock, and only after revenue generation and market acceptance should preferred equity tools be used.
• Voting Rights–If you’ve ever heard the old saying that “a donkey was a horse designed by committee,” you understand the danger of having too many people involved in the company’s decision-making process. Giving voting and board seats to early investors can create complications and frustrations long-term, not to mention deter insituional investors. Some seed investors are of great value and should be awarded board seats, but in my opinion these true angels are rare. Giving Uncle Bob and your college roommate preferred voting status and/or board seats in exchange for $20,000 is foolish. Its one thing if they are industry experts… but giving them seniority because of their relationship is naive at best.

Check back soon for future posts on:

• Setting a seed stage valuation
• What happens when entrepreneurs do bad seed deals
• How to be attractive for seed fund raising

Pitching

Guy Kawasaki has a post about How to Pickup a VC. After going through 10 rather hilarious ways on how not to start a pitch, he gives the one sure fire way to do it… cut the crap and get to the chase. My military buddies call is the KISS principle– Keep It Simple, Stupid. Don’t feel obligated to demonstrate your superior knowledge or the technology’s awesomeness in the pitch. Instead, focus on the problem and your solution. Then, you can demonstrate your knowledge and preparedness  in the follow-up questions (and meetings). Think back to dating. You don’t land a date with “that girl” by using cheap pick-up lines or self-promoting. You landed that date by focusing on her interests. VC’s are the same way. Focus on their interest (see my writings on the investment profile). 

My favorite from Guy’s list… Entrepreneur says: “I’ve always wanted to be an entrepreneur.” Venture Capitalist thinks: “… and I’ve always wanted to be a professional golfer.” In my case, I’ve always wanted to be the lead guitar for a blues/soul/rock band.